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This probably isn't news to anyone but I thought I would reiterate the point...

One of the benefits of long-term investing is that accounting changes can generally be ignored. In contrast, shorter-term investors have to be careful in reading the financials. For example, consider Amazon's accounting change that is described in an article in The Globe & Mail:

But a recent accounting change by the company will effectively goose Kindle revenue for all of 2010.

Amazon says in its disclosures to investors that it has become an early adopter of a new accounting standard called ASU 2009-13, addressing “revenue arrangements with multiple deliverables.”

In Amazon's case, the “multiple deliverables” are the Kindle hardware, the ongoing wireless connectivity, and any subsequent software upgrades for the device. Apple Inc., which has also adopted the standard, said earlier this year that its iPhones and Apple TV services fall under the standard.

Under previous accounting rules, Amazon recognized revenue from a Kindle in pieces over the life of the device, which it estimated at two years. So if a customer spent $400 (U.S.) on a Kindle, the company would recognize about $50 of revenue per quarter over eight quarters.

New rules allow Amazon to recognize a “substantial portion” of the entire purchase price upon delivery of the Kindle.

What's that worth to Amazon? It doesn't release Kindle-specific numbers, but analysts such as the team at Deutsche Bank Securities Inc. estimate Amazon will sell about $1-billion worth of Kindles in 2010.

Under the previous method, Amazon would book less than $300-million of that revenue in 2010, with the remainder pushed out into 2011 and even 2012. By recognizing about $1-billion instead, Amazon would add about three percentage points to its revenue-growth rate.

If you don't know anything about Amazon or what their Kindle product is, it's not important; what matters is that there is an accounting change and instead of booking $300 million in revenue in 2010, now Amazon will book $1 billion.

This isn't a very good example because the Kindle product is a negligible portion of Amzon's revenue, but imagine if this were a business where this product was the majority of the company's business. In such a case, spreading out revenue over 3 years versus booking most of it in the 1st year can produce different results in the near-term. If you were a short-term or medium-term investor, it would be important to understand this change. If you never knew that the accounting change caused revenue to go up 3x (for the affected product), you may mistakenly think the company's fundamentals had improved significantly.

Now, if you were a long-term investor, accounting changes, such as the one here, usually cancel out. You are just chopping up the number and shuffling it around but the total is generally the same*.

It's hard to believe but I believe the market misprices situations like these. I haven't looked up any studies or academic work on this matter but I remember Bill Miller once saying the market mistakenly re-prices stocks when accounting changes boost or hurt profits. The biggest confusion appears to be with changes to revenue recognition (this example is one such case) and tax changes (sometimes tax changes have very tiny long-term impact on profits but they have significant impact on reported near-term profits.)

Footnote:
* Do note, though, that if the company actually receives most of the cash up-front, it is quite different from if it is received over a period of time. So, chopping up the numbers can create or destroy shareholder wealth. However, there are very few companies—Amazon is actually one of those rare companies—that can structure the sales to profit off the timing. If you collect the money up-front, chances are you will be forced to pay the suppliers right away as well. For most companies, the accounting changes reflect reality and the company will have difficulties trying to profit off it (i.e. collect early but delay payments to suppliers.)

3 Response to Accounting changes can impact short-term investors

On mispricing:The 'accrual anomaly' is one the lesser-known inefficiencies in the market. Basically, it shows that investors overvalue earnings as reported by GAAP, and pay too little attention to cash flows.http://www.smartmoney.com/investing/stocks/forensic-investing-14529/

I've always wondered if this anomaly actually exists in large-caps (hard to believe), or if these studies are picking it up as a feature of small-caps, where the investor population is less sophisticated.